What Is a Credit Trust and How Does It Work?

Trusts play a significant role in estate planning, offering a structured way to manage and distribute assets. A trust is a legal arrangement where a person, known as the grantor, transfers assets to a trustee, who then holds and manages those assets for the benefit of designated beneficiaries. This arrangement allows for control over asset distribution after the grantor’s death and offers financial benefits. Among the different types of trusts, a credit trust serves a specific purpose in minimizing federal estate taxes.

Defining the Credit Trust

A credit trust, often referred to as a bypass trust, A/B trust, or credit shelter trust, is a specialized type of irrevocable trust used in estate planning, primarily by married couples. It is designed to take full advantage of each spouse’s federal estate tax exemption amount. For 2025, the individual federal estate tax exemption is $13.99 million, meaning a married couple can collectively shield up to $27.98 million from federal estate taxes. The primary goal of a credit trust is to ensure that the deceased spouse’s exemption is utilized to pass assets to beneficiaries, typically children or other heirs, without being included in the surviving spouse’s taxable estate.

It becomes irrevocable upon the death of the first spouse. It is structured to allow the surviving spouse to benefit from the trust assets during their lifetime, often through income generated by the trust, and sometimes through principal distributions for specific needs like health or education. However, the surviving spouse does not have full control over the assets, which prevents those assets from being added to their estate and thus subject to estate taxes upon their death. This mechanism helps preserve the deceased spouse’s exemption for the next generation.

The trust shelters assets and their appreciation from the surviving spouse’s estate. This differs from simply using “portability,” where the deceased spouse’s unused exemption (known as the Deceased Spousal Unused Exclusion, or DSUE) is transferred to the surviving spouse. While portability allows the surviving spouse to use the combined exemption amount, assets that appreciate after the first spouse’s death are still part of the surviving spouse’s estate and can increase their overall taxable estate. A credit trust, however, removes the assets and their future appreciation from the surviving spouse’s taxable estate entirely. This benefits high-net-worth individuals and families seeking to maximize wealth transfer and avoid future estate tax liabilities.

Establishing and Funding a Credit Trust

The establishment of a credit trust typically begins with careful planning during the lifetimes of both spouses. Provisions for creating the trust are usually incorporated into a will or a revocable living trust. This initial setup outlines the terms and conditions under which the credit trust will be formed and operated. The trust does not come into legal existence until a specific triggering event occurs.

The triggering event for a credit trust’s creation is the death of the first spouse. At this point, the will or revocable living trust directs the executor or trustee to establish the credit trust. Assets are then identified from the deceased spouse’s estate and transferred into this newly formed, irrevocable trust. The amount of assets transferred is generally limited to the deceased spouse’s available federal estate tax exemption amount.

The process of funding involves selecting appropriate assets to be moved into the trust. This selection is important for tax planning, as assets placed in the credit trust will not be subject to estate taxes at the surviving spouse’s later death. For example, if the deceased spouse’s estate has a value up to the exemption amount, that amount can be transferred into the credit trust. This strategic funding ensures that the exemption is fully utilized, benefiting the ultimate beneficiaries by reducing potential estate tax burdens.

Managing and Distributing Assets from a Credit Trust

Once a credit trust is established and funded, its ongoing operation falls under the responsibility of a designated trustee. The trustee is tasked with managing the trust’s assets, ensuring compliance with the grantor’s instructions, and protecting the interests of the beneficiaries. This includes prudently investing the trust assets to preserve and grow their value, maintaining accurate financial records, and fulfilling all tax obligations, such as filing annual trust income tax returns.

The trust document specifies the rules for making distributions to beneficiaries. While the surviving spouse often receives income generated by the trust assets, access to the trust’s principal is typically more restricted. Distributions from principal are frequently limited to specific standards, such as for health, education, maintenance, and support (HEMS). The HEMS standard guides the trustee, ensuring principal distributions meet ascertainable needs. This also protects assets from creditors and prevents their inclusion in the beneficiary’s gross estate for federal estate tax purposes.

The trustee must exercise discretion in interpreting and applying the HEMS standard, considering the beneficiary’s current and future needs, the trust’s overall size, and the needs of other beneficiaries. Distributions are generally treated as coming from current-year income first for tax purposes, with any excess attributed to principal. Upon the death of the surviving spouse, any remaining assets in the credit trust are distributed to the designated remainder beneficiaries, typically the couple’s children or other heirs, without being subject to estate taxes in the surviving spouse’s estate.